Bill Totten's Weblog

Friday, September 19, 2008

The Predator's Ball Resumes

Financial Mania and Systemic Risk

An interview with Damon Silvers. (May/June 2007)

Damon Silvers is an associate general counsel for the AFL-CIO, where he works on corporate governance, pension and general business law issues. Silvers led the AFL-CIO legal team that won severance payments for laid off Enron and WorldCom workers. He is a member of the Public Company Accounting Oversight Board Standing Advisory Group, the Financial Accounting Standards Board User Advisory Council, and the American Academy of Arts and Sciences Corporate Governance Task Force.

Multinational Monitor: What is private equity?

Damon Silvers: Private equity is a term that was designed to mislead people. The term encompasses all sorts of investment funds that take controlling interests in companies that are not public - private companies - through holding equity in them. And it confuses basically three kinds of very different investment strategies.

The first, venture capital, involves investing money in companies that are in their early stages, with new ideas and technology. The hope is that the company will ultimately be a big success and everybody that was involved at the ground floor will get very rich. That type of investment usually involves no or little debt or leverage, because people are reluctant to lend money to ventures pursuing untried ideas.

The second area of private equity is what's called the vulture fund. Vulture funds invest in companies that are in trouble, often by buying the debt of companies that are either bankrupt or about to go bankrupt, and thereby gaining control over them. This is also a type of investing that, oddly enough, involves relatively little borrowing.

The third category, which has come to overshadow the other two, is leveraged buyouts. Leveraged buyouts were a big deal in the late 1980s and early 1990s. They involve buying a company by putting up a little bit of money as equity and borrowing the rest. When leveraged buyouts really get going, leveraged buyout investors tend to borrow at least eighty percent of the purchase price and put up no more than twenty percent as equity.

The firms that you read about in the newspapers these days as "private equity firms" are almost entirely leveraged buyout firms. Leveraged buyouts got a bad name in the 1980s because they were associated with enormous job losses, and radical shrinkage and breakup of companies. Ultimately, they overleveraged, which led to some of the very big deals of the 1980s either collapsing or being relatively poor investments for long periods of time.

When this kind of activity got going again in a big way about two years ago, the deal-making firms decided rather than call it leveraged buyouts again, they would call it private equity. That blurred the distinction between what they were doing and, say, investing in new technology, which most people think is a relatively good idea.

MM: What is a hedge fund and how does private equity relate to hedge funds?

Silvers: A hedge fund is another term that doesn't tell you much about what it really is.

A hedge fund is an informal term for an investment fund that operates under a Securities and Exchange Commission (SEC) exemption. If you're running an investment fund, you typically have to register with the SEC and comply with the rather extensive set of regulations designed to protect investors. The exemption is that if you're only taking investments from sophisticated investors - from large institutions and wealthy individuals - you have an exemption from these securities rules. In the last 25 years or so, people have used this exemption to put together investment funds that both buy stock, called going long in the investment parlance, and take positions that essentially bet on the stock or the bond or the other instrument going down, which is called shorting. If you mix short and long positions, that can potentially be a way of restricting the risk in your long position.

Here's how this might work: An auto company benefits from low interest rates; more people buy cars when they can borrow with less expense. You buy the stock of an auto company and then you short debt instruments which also do well when interest rates are low. Then, if interest rates rise, your exposure to losses in your auto stock is hedged by your short position in the credit instrument.

These unregistered investment funds pursued this type of strategy, so they became known as hedge funds - they were involved in investment strategies that hedged risk. But the truth is that a hedge fund can do pretty much anything. It can invest in any type of security and it can invest in any type of strategy. It can make private equity investments. As somebody once said, a hedge fund is really a legal category in search of an asset class.

Hedge funds and private equity have a couple of things in common. Hedge funds, like private equity funds, or leveraged buyout funds, tend to borrow money - they tend to leverage their investments. That is, they have a pool of money that people have given them to invest, and they go to a bank, or some other lender, and borrow money to invest in more assets than they could have had they just taken the money they had been given by their investors. If the investments do well and return more than interest costs, then the fund can increase the rate of return for its investor. So both hedge funds and leveraged buyout funds, or private equity funds, live off of cheap debt. But this type of strategy is quite risky, because if your investments fail, your fund goes bankrupt much more quickly than if it wasn't leveraged.

The second thing they have in common is that they're both opaque. Both hedge funds and private equity funds, in general, tell the government regulators and the investing public relatively little about what assets they have, which strategies they're pursuing and what they're doing with the money that they invest.

These two characteristics - the fact that they rely on leverage and that they're opaque - have led many academics, regulators and investor advocates to be concerned about the impact of these two categories of investment vehicles on our market system as a whole.

MM: To the extent these funds are opaque, do the big institutional investors have more insight than either an average person, or even an average rich person?

Silvers: Very, very large investment funds tend to know more about the hedge funds and private equity funds that they invest in than the average person or the average small institution.

As for rich people, there are rich people and rich people. If you're a mere millionaire, if you're investing $5 million or $10 million, you don't know anything anyone else doesn't know. On the other hand, if you're Bill Gates, or basically if you have hundreds of millions of dollars to invest personally, then you can play in this league. If you have very smart people working for you or you're personally attentive, you can have access to information that other people don't have.

Because of the networks of wealthy individuals involved in this type of investing, I think some of those people may actually know more than the institutions. But it depends on the institution and it depends on the rich person.

There are certainly institutions that specialize in this area that are extremely well informed. The most obvious ones and the most prominent ones have been university endowments: Harvard, Yale and the University of Texas, which have invested very large portions of their assets in both hedge funds and private equity funds, have done very well and are very embedded in information networks around those funds.

MM: Can you elaborate on how hedge and leveraged buyout funds pose systematic risks?

Silvers: First, let's talk about dollars. No one really knows because these markets and this landscape changes very quickly, but there's probably between $1 trillion and $2 trillion today invested in hedge funds globally, and probably close to a trillion dollars in various kinds of leveraged buyout firms. Again, who knows what's happened since the recent market turmoil, but that's the basic landscape. These funds have borrowed a lot of money on top of that. And again, no one really knows exactly how much. But a good estimate is the leveraged ratio across this whole asset category is at least fifty percent, so you're talking about potentially $4 trillion or $5 trillion invested, controlled and in the marketplace through these funds. That's enough money to move markets. And it is enough borrowing to potentially affect the stability of the global banking system.

On top of that, hedge funds - this is not so much the case with private equity funds - can do anything they want, literally anything, unless they've signed a contract with their investors limiting their investment behavior, which most don't. Other types of money management, like an insurance company or a mutual fund, must tell their customers what their investment strategy is and have a legal obligation to stick with it; mutual funds also have legal obligations to maintain relatively diversified portfolios. The implications of that for systemic risk are profound. On a given day, a hedge fund could make a very large leveraged bet any place it wishes. It could take a very large leveraged short position in the currency of any given country; it could take a very large long position on the stock of any given company, or the bonds of any given company, or a particular mortgage-backed security. I don't suggest that any particular hedge fund is doing this, but nothing is stopping one from doing so if they want to. This ability to concentrate and leverage risk, and to do so with relatively little disclosure and to shift what they are doing very rapidly, makes these funds particularly capable of causing systemic risk.

In what manner am I talking about? If a hedge fund borrows money to take a large position in a security and then that security or that pool of securities collapses, or it turned out to be worth a lot less than the hedge fund thought it would be worth, what happens? First, the investors in that hedge fund can lose their money very fast. Then the institutions that lent money to that hedge fund will find themselves out of luck. If the borrowings are large enough, the financial stability of the lenders could be implicated. If that begins, then it's not just that lender and those transactions at stake. A general doubt could be triggered in the marketplace about the creditworthiness of hedge funds and the enterprises that lend to hedge funds.

We have seen something like that go on in the last few months in a series of cascading credit markets. It turned out that mortgage pools that were represented to be credit worthy were not credit worthy. There were defaults in the underlying assets (people could not pay off their mortgages). Then the people who'd invested in those funds, and borrowed money to do so, lost a lot of money and in some cases went under. Then a broader doubt began to grow in the credit markets about the credit worthiness of other funds that had similar structures and similar credit ratings. All of a sudden one day in August, no one was willing to purchase certain types of asset-backed commercial paper - in markets that a month earlier had been considered close to completely risk-free.

Credit markets have dried up and businesses have failed over the last couple of months because of this systemic cascade of doubts about the credit worthiness of whole sets of market participants, and then because of actual failures like with the Bear Stearns funds. And I suspect that we will see more of this in the next couple of months. How much more, I don't think anybody knows.

MM: What's the incentive for the private equity firms to put the deals together?

Silvers: To get very rich, astoundingly rich!

It's inherently the case that if you borrow money to buy an asset and the asset performs well then you'll make a lot more money than if you pay 100 percent cash - 100 percent equity - for that asset.

Think about a home. Suppose you buy a house for $100,000, put $20,000 down, and in the course of time the value of the house doubles. You've made $100,000 profit on your $20,000 investment. That's a five-fold rate of return. If you buy with cash, you put $100,000 down, you double it, you've made a two-fold rate of return. The difference is big.

That principle is what drives leveraged buyouts. If you buy companies by borrowing money, you can make a lot of money. But you're taking a risk. The risk is if instead of going up, the value of your company goes down, or your company starts to lose money, very quickly the equity in the company will be exhausted and the company will be bankrupt. If the company was financed largely with equity, it will have a greater ability to absorb economic downturns.

The labor movement obviously is very concerned about what happens when large pieces of our economy are financed through leverage. Companies become more vulnerable to economic instability, and so are workers. And so we have a problem with the widespread use of this type of leverage in buying and selling real companies that do real things and employ real people.

This inherent nature of leverage, of debt, is bolstered and multiplied with all of the tax subsidies that go to private equity firms.

Payments on corporate debt are tax deductible, whereas payments to equity are not. This means that, once you take the tax effect into account, any given company can support much more debt than it can equity.

A second tax subsidy that has been widely publicized is the carried interest rule. The private equity guys have structured their companies in the form of limited partnerships, and have persuaded the IRS against the obvious evidence that the money the private equity firms make as management fees should be treated as though they weren't management fees but actual returns on investments. That allows them to pay taxes at a capital gains rate on their income rather than paying income tax rates like the rest of us pay.

The punch line is that the people that run private equity firms, leveraged buyout firms - who are many of the wealthiest people in the world - are paying income tax rates on much of their personal income that is in some cases half the rate paid by most middle-income people in the United States. That is obviously something that the labor movement is viscerally opposed to. Increasingly, on a bipartisan basis, a lot of people in Congress also think this is just outrageous and ought to be stopped.

MM: How would a leveraged buyout firm put a deal together? What are the steps?

Silvers: First, you have to have some money to invest. If you're a private equity manager, you go around to wealthy individuals and pension funds and university endowments and foundations and you collect money. Then you have a pool of money, which is structured as a partnership. You're the general partner and the investors are all limited partners.

Then you look for a company which is undervalued versus what your analysts think it's really worth. Let's assume it's a public company. You put a bid together for that company. You go to banks and get a commitment letter from those banks. The commitment letter says that if for some reason this company is unable to raise money by selling bonds, then the banks will lend this company the money to cover the purchase price.

With the commitment letter from the banks, you go to the management of the company and say, "We'd like to buy your company. We'd like you and your board to vote to sell the company to us, and we will pay some premium over what the stock is trading at today. And by the way, we will offer you guys - the management of the company - the opportunity to work for us going forward, in the company after we control it. And we will give you large stakes in the equity in this company, much larger than you have today in your role as managers in a public company." The idea is to incentivize management to recommend to the shareholders that the company be sold at the price the leveraged buyout firm would like to buy it at. The subtext may be that the firm would prefer that management sell at a price lower than what the company might really be worth.

Assuming this approach to the company works and the shareholders vote the transaction through, then immediately the private equity firm goes to the bond market and borrows the rest of the purchase price. But the private equity firm is not the borrower, the company it has just bought is the borrower. So for every dollar's worth of shares that the private equity fund buys to take control of the company, the private equity firm pays maybe twenty cents and borrows eighty cents. Now they own the company.

When they own the company, the private equity firm looks for ways to make money off the company. What they'll typically do is look for ways to cut costs. Increasingly, they will also look for ways to very quickly pay out dividends to themselves as the equity holders. And sometimes this will involve actually borrowing more money on the company's credit to pay out to themselves - this is called a leveraged recapitalization. And it's resulted in companies being leveraged up over ninety percent.

Then the private equity firm will hold the company until it is economically advantageous to sell it back into the public markets. They cut costs, dress up the company to be as attractive as possible to the public markets and sell it back, aiming for a price significantly higher than the one they paid. Then they pay off the loans and pocket the difference for the private equity fund. Private equity funds say that their timeline for selling back into the marketplace is three to five years. During this boom period that's occurred over the last couple of years, in some cases that flipping period has been less than a year, particularly for some European-based deals.

This is a cycle. You borrow money, you buy companies out of the public market, you tinker around with them, and then you sell them back into the public market. The fact that it is a cycle goes to show that leveraged buyout (LBO) firms are not a substitute for the public ownership of large corporations. They are a phenomenon that lives off of the public markets. They take companies in and out. They depend for their success on their ability to sell back into the public markets.

On occasion, you'll hear academics and some in the media talk about leveraged buyouts or private equity as the new form of corporate governance. It's nothing of the kind.

It's exactly what was done in the late 1980s. It's not going to replace the public markets, it's simply going to live off of them as long as the credit market conditions are advantageous to this type of business.

By the way, the credit market conditions flipped against them this summer, and I think we're going to see a lot less private equity leveraged buyout activity in the next year or two as a result.

MM: What does it mean when you say that the leveraged buyout firms are trying to find ways to cut costs? Why do they have any better ideas to cut costs than the company did when it was publicly traded?

Silvers: They'll say that it's because they're smarter, that they know how to do better with their businesses than the managers who managed the business before. It may be true that some of these firms are run by very smart people, but there really isn't much evidence that, as a group, the people who run leveraged buyout firms know how to run any particular line of business better than anybody else.

In fact, there's a lot of evidence, built over decades, that financial management of business enterprises without any sort of industry-specific talent, is poorer at running businesses than people who really know the business. Some academics have compared private equity firms in this sense to conglomerates, which were all the rage in the 1970s, but did not perform well. A leveraged buyout firm is just another organization that owns a bunch of unrelated businesses - why should they be any better at it than the conglomerates were?

What LBO firms do have - and this is part of the reason why LBOs got a bad name - is a relatively short-term time horizon, and they're sophisticated about the capital markets that they operate in. They tend to be more willing to undertake short-term-oriented business decisions, because they're not going to have any interest in that business after their flip date.

This has led a lot of people in the labor movement to view private equity firms, as a whole, as being relatively more willing to cut companies' cost structures - meaning their employees, their capital investment - to levels that will in the long run make the business not sustainable, in the interest of making the company appear to be more profitable than it really is on the flip date. To the extent that the markets can be fooled by this type of activity, it's certainly in private equity firms' interest to do it.

There are some people who believe capital markets can't be fooled and they sort of take it as an article of faith that therefore nobody tries this kind of strategy. My own view is that after Enron and WorldCom, you just can't really credibly say that capital markets can't be fooled. There's just tons of evidence that they can be fooled and are fooled every day. And the private equity firms have an incentive to fool capital markets by dressing up their companies to look like they're healthy and capable of generating very high rates of return over a long period of time, when in fact what's happened is that they've been gutted. The LBOs have under-invested in both human capital and physical capital, and cut their employee levels to the point where they can't actually produce value.

MM: Why do creditors go along with a ninety percent leveraged business model?

Silvers: I think they're more or less not going along with it now, but they go along with it during periods of leverage-mania because it's profitable. When credit is cheap, they can put money into these deals, get a lot of fees out of them and gain the interest payments.

For banks, I think it has a lot to do with the way people are compensated, and so forth. Bond lenders do what they do because they are relying more or less on credit ratings. There's not enough data yet to really be sure what has happened during this mania, but in the housing market we know that credit rating agencies have been willing to rate pools of mortgages that were clearly risky as though they were not risky.

There is a larger issue overhanging all of it, which is that there's been an enormous glut in fixed-income financing in the last few years. This has produced what a number of central banks and international economic authorities have described as a compression of risk spread. And this is really, in our view, the source of the private equity, and to a great extent, the hedge fund boom.

It's been possible to borrow money to do things that are quite risky, like leveraging a company ninety percent, without having to pay very much to do it.

In theory, if you're going to borrow to do something really risky, you'll have to pay a very high interest rate because there's a significant risk that you'll go under and won't be able to pay off your debts. The kind of people who lend to risky enterprises make multiple risky loans with high interest rates, knowing that some will go under and the high interest rates will pay for those which go under.

The last few years, it's been possible to borrow money for very risky enterprises with a very low spread to non-risky borrowing, say a treasury bill. That compressed risk spread has fed this boom.

Where does the compressed risk spread come from? It came from a glut of dollar-denominated debt investing. And there's two sources of that. One source is that the Fed has been pumping dollar-denominated money into our economy since 2001 in an effort to end and hold off recession. The other source of it is the US trade deficit, which has produced an enormous pile of dollars in the hands of our trading partners, in particular China and Japan. In China, which is the holder of the bigger pile of dollars, the government has concluded that they wish to reinvest those dollars almost entirely in fixed income, in debt securities. So there's a trillion dollars in Chinese sovereign holdings in US dollars being put to work in the debt markets worldwide. That has fed the private equity boom, the hedge fund boom and the real estate boom.

Now suddenly, in recent months, this whole process has come to a screeching halt as a whole chain of lenders, starting in the housing area, have discovered that they weren't getting adequate compensation for their risk, and that there's a lot more risk in these debt markets than they thought.

MM: What has been the scale of private equity in the United States and globally?

Silvers: There's more than a trillion dollars involved in this type of investing. It's a global phenomenon. It is significant in the United States, but much more so in Europe. One academic source has estimated that 25 percent of the British workforce in the private sector today works for a company that is owned by a leveraged buyout firm. That's an extraordinary number, a little hard to believe. There are similarly high numbers in other European economies. In the United States, the number is nowhere near that. Our economy is much bigger and the scale of leveraged private investing in the United States in relation to our economy is nowhere near where it is in some of these European countries.

But there is no questions that, as a whole, in the last three or four years, leveraged private investing has gone from a relatively minor feature of the world's economy to a very significant one, particularly in Europe. It's no coincidence that Europe is where the political war over the behavior of the leveraged buyout firms is at its most intense. The collapse of the risky credit markets in the last few months may, at least temporarily, put a stop to this particular mania, but we just don't know. And there isn't much information today to be sure what exactly the ultimate consequences of the mania are likely to be.

MM: Should governments impose measures that would make it more difficult to do these deals?

Silvers: The public policy issues surrounding this are completely dominated by the political and economic power of the actors in this game.

In private, as far as I know, there isn't a single economist that will tell you that the tax subsidy to corporate debt, which private equity funds live off of, has any basis. I'm not just talking about left-wing economists; any economist will tell you that the tax system ought not to favor debt versus equity in the financing of companies.

A responsible public policy approach would be to ask, do we want to subsidize debt over equity, and to what levels? Is it really in the public's interest to maintain a tax system that encourages operating companies to leverage up to eighty and ninety percent when we know that's almost certain to lead to companies getting into financial distress much more quickly and companies being much less able to be productive and operate through economic downturns?

Similarly, there's just no basis to subsidize the personal incomes of private equity managers by having them pay capital gains tax on their income. It's just indefensible.

To the extent that these types of tax subsidies continue, we have a policy regime that (a) subsidizes the income of the wealthiest people in our society at the expense of the rest of us, and (b) encourages boom-and-bust cycles in private equity, which are almost certainly not good for the productive capacity of the United States' economy or of the world's economy.

Those issues should be taken up, and I think are being taken up by Congress to some degree right now, in an environment where there is less and less sympathy for straightforward subsidies for the most wealthy Americans.

I think we are less likely to get measures that deal with the systemic risk issues involved in both private equity funds and hedge funds, despite the fact that there's a crying need for that. A variety of people both in and out of government have been trying to get that type of regulation in place for some years now. The SEC took a minor step in that direction a couple years ago and had it knocked down by the federal courts. But if there isn't some responsible action, it's likely that something very unpleasant will happen, and then the issue will be taken up in an atmosphere of panic.

MM: What are the kinds of policies that might deal with these systemic threats?

Silvers: The most important one is transparency, both to the regulators and to the investing public. The hedge funds need to tell regulators and the people who invest in them what assets they hold and what strategies they're pursuing. Bank regulators need to know with a great deal more detail where banks are lending, and how banks, derivatives markets and hedge funds are interacting with each other. It would be very helpful to stop the nonsense of having the Commodities Futures Trading Commission regulate the derivatives markets, when there are derivatives that are all linked in with securities.

That's an area where we're just asking for trouble by having that kind of regulatory incoherence. That combination of things, transparency and a unified and coherent oversight system on the part of the regulators, are the two things that most need to be done.

MM: How have the private equity and hedge fund firms responded on Capitol Hill to efforts to enact some of the controls you're talking about?

Silvers: As it has dawned on them that people have figured out that they are taking advantage of outrageous tax subsidies, both the private equity funds and the hedge funds have in the last few months thrown a lot of money at Washington. They are seeking to block changes to the tax rules, including legislation that's been proposed in the Senate by Charles Grassley, Republican from Iowa, and Max Baucus, Democrat from Montana, and in the House by Sander Levin, Democrat from Michigan, and Charles Rangel, Democrat from New York. Those proposals would, in different ways, put an end to some of the tax subsidies.

The House bill would put an end to the capital gains treatment of carried interest income. It's been interesting to watch various lobbying firms, law firms and PR firms fight over who gets what cut of all the money that's been thrown at Washington by the private equity and hedge fund industries.

They have made a series of arguments, which really have no merit, about how if they have to pay taxes somehow this will hurt the pension funds that invest in their funds, and if they have to pay taxes suddenly nobody will take any more risks either in capital markets or in American business. There's a long list of utterly baseless arguments they make.

But if you have enough money, you can get people to take utterly baseless arguments seriously in Washington.

However, we're in an environment right now where I think increasingly in Congress there's less sympathy for tax subsidies for the very wealthy, and that's true on a bipartisan basis. I think that they're going to have a hard time winning this argument. At the end of the day, they're probably going to lose, at least on the tax issues. On the transparency issues, I'm not so sure. I worry that these systemic risk issues have not been adequately addressed and may not be adequately addressed.

Bill Totten


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